The Basics on Bitcoin: 11 Things to Know About This Suddenly 'Hot' Digital Currency

Since Cyprus, Bitcoin has been all over the news. So what is it? How does it work, and who runs it? Your questions answered.

Just three weeks ago, a single bitcoin -- a form of virtual currency -- sold for less than US $50 on the Mt. Gox virtual currency exchange. Now, the exchange rate hovers around US $140 per bitcoin, placing the value of the total bitcoin money supply at around $1.5 billion. The four-year-old currency -- known "primarily to fuel a shadow economy of vice," as The Guardian's Heidi Moore described it -- received mainstream attention after the Cyprus bailout debacle in March coincided with its sudden rise in value. Since then, its story has taken on a life of its own.

Source: BitcoinCharts

So what exactly is a bitcoin? In short, it is an open source, decentralized, peer-to-peer currency. There is no central bank and no physical bitcoin monies exist. (Moore says it was created "in the spirit of subversion, to trade goods while dodging the gimlet eye of financial regulators.") Individuals can exchange bitcoins free of charge as no person or institution claims ownership over the money supply, though, individuals may go through an exchange that charges a fee. Much like paper currencies, faith in its viability as a reliable means of exchange between individuals is its only value.

But as much as people like talking about bitcoin, we've found that a lot of us still don't know the basic details of how the currency works. Here, 11 facts you need to know to understand the bitcoin phenomenon.

1. A pseudonymous developer named "Satoshi Nakamoto" launched the digital currency in 2009.

The symbol of Bitcoin is a coin, though there is no physical bitcoin.

The bitcoin peer-to-peer Internet currency is the brainchild of the mysterious Satoshi Nakamoto (no one knows the individual's or group's true identity). Likely motivated by the financial collapse in 2008, Nakamoto combined peer-to-peer technologies, cryptographic techniques, and digital signatures to create the currency's system. In January of 2009, Nakamoto "mined" the first 50 bitcoins.

In the spring of 2012, Nakamoto disappeared from online bitcoin forums and has not been heard from since. Here's a list of potential candidates if you would like to try your luck at tracking him, her, or them down.

2. Getting your own virtual wallet.

The first step to getting your hands on some of this digital currency is to create your own Bitcoin wallet by downloading software from bitcoin.org or many other websites with wallet apps for download.

Next, you'll receive your Bitcoin address connected to that wallet, which is a 34- to 36-character-long series of numbers and letters that starts with the number 1. The address also ensures you remain anonymous during transactions if you wish. With this address, you can use any Bitcoin exchange to buy and sell bitcoins with any currency that is supported by your chosen exchange. Be aware that the Bitcoin wallet software is unencrypted.

Bitcoins are symbolized as BTC and only two official denominations of the currency exist: the bitcoin itself and the "satoshi," which represents the smallest denomination possible at eight decimal places. People might also refer to one-hundreth of a bitcoin as a centibitcoin, cBTC, or use other informal denominations.

If you plan on opening an account, first read Daily Beast writer Winston Ross' experience of acquiring and using bitcoins to see what it's like.

Essentially, the entire network relies on something called a "Blockchain," the shared public transaction log containing the details of every transaction. The open nature of the settled transactions allows bitcoin servers, or nodes, to verify all exchanges between Bitcoin wallets.

Atransaction is defined as a transfer of value between two Bitcoin addresses. The system confirms the identity of the recipients by checking the wallet's "private key," a secret piece of data that acts as a signature for the wallet. The signatures also use mathematical proofs to confirm authenticity. Once "signed," no one else can change the details of the transfer of value.

Cryptography, or mathematical security protocols, helps protect the Blockchain from hackers and manipulation, to a degree (see number 9, below). The system's particular cryptographic algorithm is called "mining" and it is managed by "miners" -- anonymous Bitcoin servers and nodes run by anonymous individuals. The miners confirm transactions by adding new "blocks," or transaction records, to the Blockchain by solving mathematical proofs, which requires increasingly stronger computing power.

The operators of the miners receive bitcoins -- 25 per transaction, to be precise -- as compensation and verification of their work, which creates incentive for them to correctly ensure the integrity of the system. This compensation also serves the dual purpose of expanding the money supply, which cannot exceed 21 million.

(An increased volume of transactions indicates an increased demand for bitcoins. Under the current system, the amount paid for a reward after mining will halve every four years to ensure the money supply does not exceed its ceiling.)

In the first four years of Bitcoin's existence, 10.5 million bitcoins were created; projections state that the 21 million limit will be reached in 2140.

Source: Bitcoin wiki

This computationally intensive process is supposed to be analogous to the arduous process of mining precious metals, such as gold and silver.

As the currency has been obscure until now, it has been deemed the currency of choice for crime syndicates and drug sellers. Now bitcoin is becoming popular with legitimate consumers and investors.

4. You can use bitcoins for almost any purchase, even to buy cars.

Can you really use bitcoins in the marketplace? A father and a son told Business Insider yesterday that they recently sold a Porsche on Craigslist to a young businessman who paid for his car with 300 bitcoins, or almost $39,000. The buyer sent a surrogate to pick up the car and the two parties remained on the phone while the 30-minute transaction took place.

Many online businesses, services, and games are allowing users to make transactions with bitcoins. Pizzaforcoins.com, for example, allows a person to use bitcoins to pay for Domino's (NYSE:DPZ) pizza or any pizza from the nearest pizzeria. With Bitcointip you can transfer bitcoins to your favorite writer or commentators on Reddit. Rugatu allows users to post questions on a message board, along with a bounty of whatever the user thinks an answer is worth. Once someone answers the question, the author of the question can release the posted bounty to that user. For example, one question reads, "How much do you think bitcoin will cost on 7 Apr?" The bounty is 100.00 mBTC (an mBTC is 1 thousand of one bitcoin). (Not every question is about bitcoin). In the free-to-play game Mine Things, you can buy additional in-game bonuses with bitcoins. Coindl is like the iTunes (NASDAQ:AAPL) of Bitcoin, allowing users to buy songs for 0.019 BTC each. Coinabul allows users to exchange their bitcoins for precious metals. As a specific example, you can buy one South African Gold Krugerrand (1 Troy ounce) for 12.5890 BTC. (Note: We have not tried buying any of these items or services from listed businesses.)

The list of items purchasable using bitcoins is extensive: See this site, or this one, for more outlets where you can spend bitcoins.

5. Trading volume has almost reached $20 million on Mt. Gox exchange.

There are 88 virtual currency exchanges through which it's possible to swap most paper currencies for bitcoins. BitcoinCharts tracks the value of bitcoins versus paper currencies on different exchanges in real time.

Established in July of 2010 in Japan, the first bitcoin exchange, Mt. Gox or MTGOX, remains the most used by volume, accounting for roughly 70% of total exchange volume. On the exchange, a user can buy bitcoins with a national currency. (Bitcoins must always be involved in a transaction as trading between national currencies is not allowed on the exchange.) Mt. Gox supports the trading of the US dollar, the euro, the Canadian dollar, the British pound, the Swiss franc, the Australian dollar, the Russian ruble, and other currencies. Trading volume by US dollar amount has grown on Mt. Gox, reaching almost $20 million yesterday.

Source: BitcoinCharts

Check out the other exchanges on Bitcoin's official wiki here. Here is a list of exchanges and the currencies accepted for Bitcoin trading. Despite the recent events in Cyprus, the US dollar is the most exchanged currency, with 72% Bitcoin currency exchanges involving the US dollar.

6. Bitcoin ATMs will soon appear in more than 30 countries.

An image of a Bitcoin ATM, posted on bitcointrading.com.

Jeff Berwick, CEO of the Dollar Vigilante Media, founder of StockHouse.com, and Bitcoin ATM co-founder, says he will open the first two Bitcoin ATMs in Cyprus and Los Angeles in the next two weeks. The ATMs won't hold or distribute any physical bitcoins as none exist. Rather, after showing their QR code to the machine or entering a wallet code, individuals will be able to insert paper currencies into the ATM and purchase bitcoins for virtual wallets or bitcoin accounts. Conversely, bitcoins can be converted to paper currencies at the ATMs.

In a post on the Dollar Vigilante blog, Berwick announced, "I have decided to move forward with what I believe could be the next multi-billion-dollar business venture: Bitcoin ATM....It is wholly our intention at Bitcoin ATM to put the company in the right position to open its very first ATM in Cyprus." Berwick expects the debasement of national currencies to increase Bitcoin's value.

Later, in an interview with Business Insider, he disclosed, "We now have orders for 300+ machines in 30+ countries and are moving quickly to handle the demand."

7. You can even short bitcoins.

Some traders think the run-up in Bitcoin's value is irrational; for them, certain exchanges have made it possible to short the bitcoin.

Simone Foxman reported earlier this week on two such exchanges: Bitifnex, a Hong Kong-based exchange that allows traders to open long and short positions in the bitcoin, and iCBIT, based in Stockholm, which allows traders to buy and sell futures contracts denominated in bitcoins.

Founded in 2007 on Facebook (NASDAQ:FB), Ven is another digital currency, used by members of the social network service Hub Culture. It was the first virtual currency to be used for commodity and carbon credit trading. The value of one ven is determined by a basket of currencies, commodities, and carbon futures determined by Hub Culture, which operates as the currency's "central bank." The currency has an estimated $2 million USD base, as opposed to bitcoin's $1 billion base. Other virtual currencies include Litecoin, IXcoin, PPCoin, and NovaCoin. Amazon (NASDAQ:AMZN) will launch its own virtual currency in May called "Amazon Coins" for use on the Kindle Fire to purchase apps, games, and in-app items.

Also worth keeping track of is Ripple, an open-source project that is developing a decentralized payment network. Theoretically (because it is still being developed), one of the major features of Ripple's network would be a peer-to-peer system by which people could exchange money (make payments, loans, etc.) via a monetary honor system based on trust already existing between users. Hence, the rightful transfer of financial capital would be backed entirely by social capital. Ripple could be a platform for the further proliferation of bitcoins. For more details on Ripple, check out its website here.

Large payment services have begun mulling the use of other virtual currencies. The Western Union Company (NYSE:WU), for example, may facilitate online transactions with virtual currencies as the company looks to expand its market share of processing digital payments.

9. Hackers Breach Mt. Gox Yesterday

While the Bitcoin system itself has a thorough verification system, individual wallets and exchanges can still be hacked. Yesterday, Mt. Gox reported that hackers caused a distributed denial-of-service attack. Also, Bitcoin wallet company Instawallet shut down indefinitely yesterday after reporting that someone fraudulently accessed the system's database. These security breaches are not isolated incidents. In 2011, several hacking incidents occurred.

On the night of June 12, 2011, a hacker (or hackers) stole 25,000 bitcoins from someone aptly calling him or herself "All In Vain." The cryptographic system that makes all transactions permanent after 10 minutes actually worked in the thief's favor in this instance: Once the illegal transaction had been added to the Blockchain, it became irreversible. A total of $500,000 in bitcoins simply vanished. The stolen bitcoins are now worth over $3 million.

The following week, a hacker compromised Mt. Gox, causing the price of a bitcoin on the exchange to plummet from $17 to pennies within a few minutes. The value of a bitcoin on other exchanges dropped by a less dramatic amount, but the event shook confidence in the system. Mt. Gox closed the exchange to launch an investigation.

Source: Wired

Then on July 29, the eWallet MyBitcoin, a former third party holder of bitcoins, shut down its website, only to reopen a few days later to report its shopping cart interface had been compromised. It eventually issued a statement saying 51% of its total bitcoin holdings had been stolen and the remaining 49% would be returned to customers. Some speculate MyBitcoin may have been a scam from the beginning.

10. The US government and others could declare Bitcoin illegal and send the price lower or all the way to zero, nullifying its recent gains.

The Chinese government has already curtailed the use of virtual money. In June of 2009, the Ministry of Commerce decreed that virtual money that can be exchanged into physical money can only be used to trade in virtual goods and services. Online currencies such as bitcoins or prepaid cards of cyber goods cannot be used to buy physical goods and services in China.

The risk that criminals will use digital currency for money laundering currently tops government fears. Last month, the Financial Crimes Enforcement Network of the US Treasury Department stated that money-laundering rules and Bank Secrecy Act apply to virtual currencies. Firms and exchanges that issue bitcoins now need to follow the same regulations as traditional money-order providers like Western Union. Transactions of more than $10,000 now need to be reported even though the identity of virtual wallet users remain anonymous.

More people might be convinced to give Bitcoin a shot if paper currencies continue to be debased, however, or if more situations like Cyprus -- where assets faced the risk of seizure -- occur. Government dysfunction is Bitcoin's best friend.

11. Some people think Bitcoin is in a bubble.

Because there is nothing constricting the price of bitcoins besides what people are willing to pay for them, a bubble could grow significantly before it pops if people's faith in the digital system grows too strong.

Search interest in Bitcoin
Source: Google Trends

Henry Blodget of Business Insider published a story yesterday explaining why the bitcoin market is set up to be the perfect speculative bubble, explaining that it has the compelling, underlying story, the "sexy new-ness" that consumers have to research to understand, a finite supply, a subjective value that makes its price justifiable at almost any level, and the requisite high levels of risk and excitement.

Blodget points out that a reversal of Bitcoin's value could be triggered by any number of events, including government regulation (Congress has the sole power to print money and Bitcoin does behave like money), hackings (we've seen a great deal of this already), and ultimately, a failure to gain wide acceptance (this, of course, remains to be seen). He compares the supposed bitcoin bubble with the 1990s Internet bubble, when the prices of dot-com company stocks saw their value skyrocket until the pop. The biggest difference is, "there really is no fundamental way to value Bitcoin."

Felix Salmon of Reuters also believes Bitcoin has entered bubble territory because of its price explosion and may drop in value because of its hacking risks. Yesterday's two security breaches caused a brief plunge in value.

As of this morning, one Bitcoin went for $136 on the Mt. Gox exchange.